Yearly Archives: 2022

Snapped

SNAP broke yesterday. I’ll explain two reasons why.

Yes, the company blew the quarter. Dramatic swings in guidance don’t instill joy.

But the losses occurred before anybody talked about them.  SNAP closed Monday at $22.47 and opened Tuesday for trading at $14.49 and closed at $12.79.

It lost 36% when most couldn’t trade it and shed just $1.30 during official market hours.

Illustration 135866583 © Jm10 | Dreamstime.com

How is that fair?

Regulations are meant to promote a free, fair and open stock market. I think premarket trading should be prohibited because it’s not a level playing field.

Who’s using it? Big institutions with direct access to brokers who operate the markets running around the clock. Hedge funds could dump shares through a prime broker, which instantly sells via so-called dark pools.

And the hedge funds could buy puts – and leverage them – on a whole basket including the stock they dumped, peers, ETFs, indices.  All outside market hours.

Something unfair also happens DURING market hours. I’ll explain with my own experience as a retail trader using our decision-support platform, Market Structure EDGE.

It’s not that my trade was unfair.  I understand market structure, including how to use volatility, trade-size, liquidity and stock orders to best effect.  I made money on the trade.

But it’s instructive for public companies, traders, investors.

I sold 50 shares of NXST. Small trade, with a reasonable return. I pay a modest commission at Interactive Brokers to observe how trades execute.

Most times I buy and sell 100 or fewer shares, often 95 or 99. The average trade-size in the market is less than 100 shares so I don’t want to be an outlier. And you’re looking for blocks? Forget it. The market is algorithmic.

And I know the rules require a market order, one accepting the best offer to sell, to execute immediately at the best price if it’s 100 or fewer shares.

Stay with me – there’s a vital point.

NXST trades about $7,300 at a time (a little under 50 shares), the reason for my trade-size. And it’s 2.1% volatile daily. Since it was up 2% during the day, I knew it was at the top of the daily statistical probability, good time to sell.

I checked the bid/ask spread – the gap between the best bid to buy and offer to sell.  Bid was $176.01, offer was $176.25. A spread of $0.25. That’s big for a liquid stock.

So I used a marketable limit order – I picked a spot between them, aiming to the lower side to improve the chance it filled: $176.05. I was wanting to leave.

The trade sat there for a bit, and then filled.  I checked. It split into two pieces, 45 shares at “Island,” which is Instinet, the oldest Electronic Communications Network, now owned by Nomura. I paid a commission of $0.19.

And the other piece, five shares, also executed at Instinet at the same price.  And I paid $1.02 in commission. For five shares!

What the hell happened? 

This is how the ecosystem works.  And this rapid action can smash swaths of shareholder value, foster wild and violent market swings – especially during options-expirations (yesterday was Counterparty Tuesday, when banks square monthly derivatives books, and it was a tug-of-war) – and, sometimes, work masterfully.

It’s market structure.

My broker sent the trade to Instinet, determining by pinging that undisplayed shares there would fill it.

And one or more Fast Traders hit and cancelled to take a piece of it, permitting my broker to charge me two commissions, one on five shares, another on 45 shares.

And now my one trade became ammo for two. The going rate at stock exchanges for a trade that sets the best offer is around $0.25 per hundred shares – the exact spread in NXST.

Yes, that’s right. Exchanges PAY traders to set prices. I traded 50 shares, but since the order split, it could become the best national offer two places simultaneously, generating that high frequency trader about $0.15.

What’s more, my order originated as a retail trade, qualifying for Retail Liquidity Programs at stock exchanges that pay an additional $0.03.

So my intermediary, Interactive Brokers, made $1.21. Some high-frequency trader probably made another $0.18 for breaking the trade up and buying and selling it at the same price two places. Zero risk for an $0.18 return.

Do that 100,000 times, it’s big, risk-free money.

It didn’t cost me much. But suppose it was 500,000 shares or five million?  Every trade navigates this maze, public companies and investors, getting picked and pecked.

Not only do costs mount for moving any order of size but the market BECOMES this maze. Its purpose disappears into the machination of pennies. Oftentimes it’s tenths of pennies in liquid stocks.

And you’re telling your story, spending on ESG reports, a total approaching $10 billion for public companies complying with rules to inform investors.

And the market is the mass pursuit of pennies.  Yes, there are investors. But everybody endures this withering barrage that inflates on the way up, deflates on the way down.

And it’s wrong that the mechanics of the market devolve its form into the intermediated death of a thousand cuts. Is anyone going to do anything about it?

Create and Destroy

The Terra Lunacy (cough cough) is about creating and destroying. 

If you’re thinking, “Lord, I want to read about cryptocurrencies like I want to use a power tool on a molar,” hang on.  It’s about stocks.

Illustration 247279717 / Cryptocurrency © Vladimir Kazakov | Dreamstime.com

But first, here is Market Structure 101, public companies and investors.  If the market is going to turn, or if money is going to shift from Value to Growth, it almost ALWAYS happens at options-expirations.

This is why you shouldn’t report earnings during expirations.

It’s not hard. Sit down with your General Counsel and say, “There are about $900 trillion of derivatives notional value tied to the monthly expirations calendar. Our market cap is a lot less than that.  So is the entire stock market, all the stock markets on the globe. All the GDP on the planet. So how about we don’t report results till AFTER those expire?”

Here’s the 2022 calendar.

In the 1990s, Active money was over 80% of market volume, and you could report whenever the hell you wanted.  In 2022, Active money is less than 10% of volume. 

Read the room.  Don’t hand your hard-earned earnings to the buffalo herd of speculators in derivatives to trample.  Remember that song by Roger Miller, you can’t roller skate in a buffalo herd?  Wise words.

And that’s why the market surged yesterday and may do it again.  It’s short-term trading into expirations, moving stocks to profit on sharper moves in options. It will take more than that to be durable.

Now back to Terra Luna.  A so-called stable coin pegged algorithmically to the US dollar, TerraUSD or UST for short, imploded last week.

It was supposed to be tethered to the dollar.  Monday it was trading at nine cents.  The token used to keep it aligned with the dollar, called Luna, was trading for a thousandth of a penny after at one point being worth over $100.

What’s this got to do with stocks? Exchange Traded Funds have the same mechanism.  It’s the create/destroy model. 

The point of stable coins is that by pegging them to something else, they’re supposed to be…stable.  Otherwise, supply and demand determine the value.

TerraUSD is supposed to be worth $1.  Always.  To sustain that value, Terra and Luna act like two sides of a teeter-totter.  One Terra can be burned, or destroyed, in exchange for one Luna, and vice versa.

So if Terra drops to $0.99, smart arbitragers will destroy Terra and receive Luna, bringing Terra back up to $1. Luna could become worth a lot more than $1 if the ratio skewed big toward Terra.

ETFs work the same way.  ETFs are pegged to a basket of stocks.  So stocks are Terra, ETF shares are Luna. 

As an example, XLC is the Communications Services ETF from State Street. It holds 26 of the roughly 140 stocks in the sector. Issued against that basket of stocks are ETF shares that when created had the same value as the aggregate basket of stocks.

If the stocks rise in value but the ETF lags behind, traders will scoop up ETF shares and return them to State Street, which gives them an equal value from the basket of stocks, which are valued in the open market at higher prices.

So traders can then sell and short the stocks.  That’s an arbitrage profit.

And if spooked investors sell the ETF, the process reverses. Market-makers gather up ETF shares and State Street redeems them – destroys them – in trade for stocks.

The idea is to continuously align the two (of course, that means a great deal of the trading between the ETFs and your stocks is arbitrage). 

The trouble is, even though the value of the stock market has come down markedly, the supply of ETF shares has actually risen. In fact, in March nearly $1 trillion of ETF shares were created or redeemed and creations sharply exceeded redemptions.

The Investment Company Institute publishes that data and we’ve tracked it since 2017.

When both ETF shares and stocks are losing value and prices are moving wildly, it’s much harder for arbitragers to calculate a low-risk trade.  That’s why markets swoon so dramatically now.

If market-makers stop buying or selling one or the other, we’ll have an equity Terra Luna.

It’s a small risk. But because ETFs are so pervasive ($6.5 trillion in the US market alone), at some point we’ll have a colossal failure.

It’s not fearmongering. It’s math.  We can see in the data that money has an easy time getting into the stock market, thanks to vast ETF elasticity, but a hard time getting out.

It will take a dramatic and sustained move down to cause it.

I suspect we came close in the last two months.  Maybe May options-expirations will save us, but the math says more trouble lies ahead.  The prudent foresee evil and hide themselves from lunacy.

Experience

“The market structure is a disaster.”

That’s what Lee Cooperman said in a CNBC conversation yesterday with “Overtime” host Scott Wapner.

What he thinks is wrong is the amount of trading occurring off the exchanges in so-called dark pools and the amount of shorting and short-term trading by machines.

I’m paraphrasing.

Mr. Cooperman, who was on my market-structure plenary panel at the 2019 NIRI Annual Conference, decries the end of the “uptick rule” in 2007. It required those shorting stocks to do so only on an uptick.

To be fair to regulators, there’s a rule. Stocks triggering trading halts (down 10% in five minutes) can for a set time be shorted only at prices above the national best bid to buy. It’s called Reg SHO Rule 201.

But market-makers are exempt and can continue creating stock to fill orders. It’s like, say, printing money.

Mr. Cooperman has educated himself on how the market works. It’s remarkable to me how few big investors and public companies (outside our client base!) know even basic market structure – its rules and behaviors.

Case in point.  A new corporate client insisted its surveillance team – from an unnamed stock exchange – was correct that a big holder had sold six million shares in a few days.

Our team patiently explained that it wasn’t mathematically possible (the exchange should have known too).  It would have been twice the percentage of daily trading than market structure permits.  That’s measurable.

Nor did the patterns of behavior – you can hide what you own but not what you trade, because all trades not cancelled (95% are cancelled) are reported to the tape – support it.

But they’re a client, and learning market structure, and using the data!

The point though is that the physics of the stock market are so warped by rules that it can’t function as a barometer for what you might think is happening.  That includes telling us the rational value of stuff.

You’d expect it would be plain crazy that the stock market can’t be trusted to tell you what investors think of your shares and the underlying business.  Right?

Well, consider the economy.  It’s the same way.

Illustration 91904938 © Tupungato | Dreamstime.com

The Federal Reserve has determined that it has a “mandate” to stabilize prices.  How then can businesses and consumers make correct decisions about supply or demand?

This is how we get radical bubbles in houses, cryptocurrencies, bonds, equities, that deflate violently.

Human nature feeds on experience. That is, we learn the difference between good and bad judgement by exercising both.  When we make mistakes, there are consequences that teach us the risk in continuing that behavior.

That’s what failure in the economy is supposed to do, too.

Instead, the Federal Reserve tries to equalize supply and demand and bail out failure.  

Did you know there’s no “dual mandate?”  Congress, which has no Constitutional authority to do so, directed the Fed toward three goals, not mandates: maximum employment, moderate long-term interest rates and stable prices.

By my count, that’s three. The Fed wholly ignores moderate rates. We haven’t had a Fed Funds rate over 6% since 2001.  Prices are not stable at all. They continually rise. Employment? We can’t fill jobs.

From 1800-1900 when the great wealth of our society formed (since then we’ve fostered vast debt), prices fell about 50%.  The opposite of what’s occurring now. 

Imagine if your money bought 50% more, so you didn’t have to keep earning more.  You could retire without fear, knowing you wouldn’t “run out of money.”

Back to market structure.

The catastrophe in Technology stocks that has the Nasdaq at 11,700 (that means it’s returned just 6% per annum since 2000, before taxes and inflation, and that matters if you want to retire this year) is due not to collapsing fundamentals but collapsing prices.

How do prices collapse?  There’s only one way.  Excess demand becomes excess supply.  Excess is always artificial, as in the economy.

People think they’re paying proper prices because arbitragers stabilize supply and demand, like the Fed tries to do. That’s how Exchange Traded Funds are priced – solely by arbitrage, not assets. And ETFs permit vastly more money to chase the same goods.

It’s what happened to housing before 2008.  Derivatives inflated the boom from excess money for loans.

ETFs permit trillions – ICI data show over $7 trillion in domestic ETFs alone that are creating and redeeming $700 BILLION of shares every month so far in 2022 – to chase stocks without changing their prices.

And the Federal Reserve does the same thing to our economy.  So at some point, prices will collapse, after all the inflation.

That’s not gloom and doom. It’s an observable, mathematical fact.  We just don’t know when.

It would behoove us all to understand that the Federal Reserve is as big a disaster as market structure.

We can navigate both. In the market, no investor, trader or public company should try doing it without GPS – Market Structure Analytics (or EDGE).

The economy?  We COULD take control of it back, too.

Hysteresis

You never know where you’ll hear a new vocabulary word. 

It’s not the word that matters but what it connotes.  And the context in which one hears it.  In this case, it was hedge-fund billionaire Paul Tudor Jones on CNBC Squawk Box yesterday, talking about stocks and bonds.

He said you don’t want to own them. He said, paraphrasing, there’s hysteresis at work in markets. 

Now, I think I’ve got a decent vocabulary. I read Allan Bloom’s “The Closing of the American Mind” in college and recorded roughly 32% of its entire contents as words I didn’t know.  Like palimpsest.

And I didn’t know hysteresis. It’s the delayed effect of causes. The relationship between an outcome and the history preceding it.

Illustration 27944908 © Mopic | Dreamstime.com

I guess it’s good news he didn’t say “there are no words to describe how bad things are in markets.” Warren Buffett, speaking this past weekend to the Berkshire masses gathered in Omaha, called financial markets “a gambling parlor.”

By the way, did you know Berkshire Hathaway holds no earnings call?  They just put out a Saturday press release. Hm, one wonders if we’re all confusing busy with productive.

Anyway, Mr. Buffett said he finds the amount of speculative betting “obscene.”

I’m reminded of a vignette from David Mamet’s book, Recessional. He’s in New York and observing street experts working suckers with Three Card Monte.

You know it? Somebody turns three cards up and says follow the queen, or whatever.  Then he turns them over and shuffles them.

Mamet says Three Card Monte is not a game of chance.  Not a game of skill.  It’s not a game.

And that’s the stock market. It is not a game for those setting most prices. I told traders using our quant decision-support platform that all the middlemen, the toll-takers like money managers, ETF sponsors, market-makers, brokers, exchanges, make money while investors and traders struggle.  Look at Citadel’s great April.

For intermediaries, it’s a job, and the rules and processes are well-known to them. The purpose of the stock market is to facilitate a continuous auction of everything in tiny bits. So the SEC has decreed.

That is, there must always be prices for all stocks, even if the prices are wholly disconnected from supply/demand reality.

Public companies, consider the chasm between Mr. Buffett’s statement and what you want.  You’re after shareholder value, not stimulating the “gambling parlor.”

What are you going to do to sort the one from the other? You can’t do it with “settlement data.”

Bill Gurley, guru of venture capital in Silicon Valley at Benchmark Capital tweeted that earnings multiples have always been a “hack proxy.” He said there’s a lot of what he called “unlearning” coming to the multitude too young to know a bear market.

I know looking at the numbers coming out of Robinhood and other parts of the market that retail traders have taken a drubbing by not understanding what’s happening.

The stock market functions exactly as its rules specify. It’s the system. The word “hysteresis” says the system reflects the state of its history.

And the history of the market, as with money, credit, labor, is about increasingly pervasive government control. Which means market forces lose control.

Bonds and equities are for the first time in decades falling at the same time.  The dollar is at levels one finds during crises when money rushes to it for capital-preservation. The economy doddered into a GDP decline last quarter.

We may be in a financial crisis already. We don’t see it because the credit-overextension causing it isn’t emanating from some part of the economy but from the government itself.

What about jobs, openings, strong consumer credit and balance sheets? They’re part of hysteresis, the milieu resulting from what came before it. They reflect what was stimulated into existence, not what can survive without stimulation.

I’m not saying everything is about to fall apart. The stock market could go on a tear again, although supply/demand trends need big change to make that hold.

Rather, I think the trouble is all the effort to manage outcomes. A handful of members of government, and central bankers and regulators are trying to run everything. The few are not smarter than the many. Hysteresis for any cultural experiment shows it.

Stenosis is a word describing the consequences of narrowing neural passages. Stentorian means loud, thundering.

I think hysteresis in our financial markets is breeding economic stenosis that will lead to stentorian tumult.  We best get prepared (we have the navigational data).

For the Birds

Did you know the Caribbean is full of brown boobies? 

The blue-footed brown booby, about the size of a seagull.  We’re just back from sailing St Martin and St Barts, where the critters of both sea and sky delighted.

Unlike the stock market, apparently, which has gone to, um, the birds. 

By the way, best food in the islands?  Grand Case on St Martin. It’s French. Need I say more?  On our boat, we had French food, French wine, French chef.

It’s a wonder we left. I gained five pounds. You can see it in the photo, aboard our catamaran in St Barts (more trip photos if you’re interested).

Tim and Karen Quast aboard Norsegod in St Barts Harbor (courtesy Tim Quast).

Back to stocks, we should have expected cratering markets because fundamentals have deteriorated dramatically.

Oh no, wait. They haven’t. 

Zscaler (ZS), which has been crushing expectations every quarter, is up just 6.7% the past year now after rising over 500% the past five years. It’s down 33% the last six months.

Philip Morris (PM), which is not growing, is down 7% the past five years but up 8% the past six months.

The popular explanations for why these conditions exist have reached such shrieking insanity that I might be forced to return to the sea.  And French food.

First, let’s understand how stocks go up.  Not the “more buyers than sellers” version but the mechanics. 

There is demand.  It can come from investors, traders or counterparties. Active investors buy opportunity, Passive investors buy products – growth, value, etc. Traders chase arbitrage (different prices for the same thing). Counterparties buy or sell to meet or mitigate demand for derivatives like options.

When all converge, prices explode. 

And there are compounding factors. Many investors now prefer Exchange Traded Funds (ETFs), which don’t increase the SUPPLY of stocks, just the DEMAND for them.

And traders buy or sell short-term prices with connection only to previous prices, leading to spiraling short-term gyrations.

And derivatives as both implied demand and supply magnify moves.

Are you with me still? Think this is for the birds?

The Tetris of the stock market, the arranging of these blocks, distorts perceptions of supply and demand and fosters absurd explanations.

And over time, it erodes realized returns.  All the toll-collectors – money managers, ETF sponsors, trading intermediaries, stock exchanges, counterparties – get rich.

As of yesterday, the Nasdaq is up about 6.5% annually since March 2000, before taxes and inflation and without respect to risk premia. Tech stocks move 3.5% intraday daily.

You see? Daily price-moves are more than half the average expected pre-tax returns. That’s because of what happens when all the Tetris blocks start falling.

Here’s how. Active investors stop buying equities. Passive investors slow allocations and see redemptions.  Speculators stop setting prices. ETFs have to redeem shares so compounding demand is suddenly replaced by a vacuum. Implied demand via derivatives vanishes.

And prices implode.

This is how the DJIA drops 800 points in a day.

And we haven’t even talked about short volume.  The SEC permits intermediaries to create stock when no real supply exists to satisfy it. That is, they can short stocks without borrowing.

That works great on the way up as it provides supply to rising prices that would otherwise go unsatisfied. On the way down, we become aware that the implied demand in created stock just doesn’t exist.

So, Tim. What can we do in this market?  

You can’t control it.  We could fix it if we stopped letting shilling Fast Traders set prices and create stock.

If we junked the continuous auction market and returned to periodic auctions of real demand and supply. No real buyers or sellers, no prices.

And stock markets should actually compete by offering separate “stores” that aren’t connected electronically and forced to share prices. As it is, markets are just a system.

Alas, none of this will happen anytime soon.

So.

We can continue as companies, investors and traders fooling ourselves that fundamentals drive markets.  Or we can learn how markets work. The starting point.

Otherwise, we’re like somebody reading the opening line today. “Did he just say ‘boobies’?”

I was talking about birds.

We need to understand the topic. The market (ask us, we’ll help).

Troubling Signs

Ahoy!

As you read, we are stopping in Charlotte en route to a 2pm arrival in Sint Maarten in the Caribbean.

Illustration 91269233 © Dharshani Gk Arts | Dreamstime.com

We saw the inflation print at 8.5%, plunging consumer confidence, rising credit risk, the supply-chain morass, and said, “Let’s flee to the sea.”

Okay, not really. We reset this sailing trip that vanished into the Pandemic.  Weirdly, we need no Covid test to see the sand and sea but for us citizens of the Land of the Free, we can’t get back in our OWN COUNTRY without one.

After being shot, boosted and afflicted with Covid in roughly that order.

We the People need to put the little despots in their places, power-seekers lording it over others without respect to math, science or common sense.  Untenable.  Unacceptable.

Back to market structure.  And monetary policy. 

Options expire this Good Friday short week, today and tomorrow. Trading is a tug of war between parties to expiring options and futures on Treasuries, currencies, interest rates, commodities, equities and bonds, and the counterparties with risk and exposure on the other side.

Don’t expect the market to be a barometer on investor-sentiment right now.

And new options trade Monday. Then counterparties square books Tuesday. Volatility derivatives expire Wednesday.

What will be apparent is if risk-taking is resuming.  I think Mon-Tue next week (Apr 18-19) are key.  Look, you can’t peg the day. Could be before, could be after.  But the market will either turn because investors and traders reset swaths of options and futures or we could get clocked.

No middle ground?

Broad Sentiment signals risk.  Might be a couple months away, or not.  Data going back the past decade that we track show that Broad Sentiment with a 90-day rolling read near 5.0 precedes a steep decline.

That’s about where it is.  History warns us.

What about the risk of recession?  Well, of course there’s risk.  Central banks globally exploded the supply of currency and shut down output. Nothing could be more damaging to economies.  Trying to remedy that catastrophe will take a toll.

And the Federal Reserve knows it and knows it must get interest rates back to a level that leaves room to chop them to zero to try to forestall an economic collapse. 

The Fed is motivated to stock up some ammo, not to “normalize rates.” The quickest way to do that is to lift overnight rates and start selling off bonds. If demand for bonds falls, interest rates rise.

That simple. And the Fed is wholly willing to put everything and everyone in jeopardy in order to give itself policy tools. 

I’m not opposed to raising rates. I’m opposed to low rates that devalue savings and purchasing power and encourage debt and consumption.

Impact on equities?  I think we’re seeing it already.  Passive Investment marketwide has fallen from 20.4% of trading volume over the trailing 200 days, to 18.8% now.

Doesn’t seem like much. But a sustained recession in demand from indexes, ETFs and quants will reduce stock prices.  Derivatives demand is down too, from 18% to 17.2%.

Mathematically, that’s an 8% long-term decline in Passive Investment, 4% drop in derivatives demand. Is a 12% reduction in real and implied demand meaningful?  

Absolutely.

So, it’s a matter of the degree of effect, and if or when that trend reverses.  A trend-change across the whole market is unlikely here at April options-expirations. 

How about earnings season?  Only if it’s a barnburner, which is improbable.

I think the best chance is June options-expirations, the next time big money can make meaningful changes to asset-allocations.  In between are Russell rebalances in May.

I’m neither bull nor bear. We’re data analysts. We track the trends.  There are troubling signs here.  Yes, they could dissolve again under the inexorable repetition of There Is No Alternative.

But if not, there’s a rough ride ahead.  So.  You will find us on a boat.  See you Apr 27.

Interest(ing) Rates

Cathie Wood says don’t do it.

Raise interest rates, that is.  The founder of Ark Investment Management and guru to retail traders of Tech stocks says the Federal Reserve is playing with fire.

Why?  Because growth is fragile and consumer confidence is woeful.  Hike rates, and we plunge into recession.

Illustration 44644519 © Tashatuvango | Dreamstime.com

I enjoy economics almost as much as market structure. I’ve got observations.

What’s the big threat Ms. Woods sees in higher rates? US Gross Domestic Product is 70% consumption – the stuff we buy.  The consumption linchpin is home equity.

As homes increase in value, consumers borrow equity to fuel both the confidence to go out and buy stuff, and the means to consume big-ticket items like cars and appliances.

If interest rates rise, people stop buying and refinancing homes, and the torrent of cash driving consumption shrivels.

I think the Federal Reserve knows it’s going to muzzle the economy. But The Fed will try to rapidly raise interest rates so it can hack them back to zero as the economy slips. Maybe that’ll juice consumption anew, forestalling recession.

The whole concept is jacked. The Fed shouldn’t be manipulating consumer behavior at all, because then it’s artificial.

The Fed touts its dual mandate – stable prices, low unemployment – as an unassailable hieratic purpose. Well, why should the Fed allocate labor and capital? You’d expect that from a despotic politburo, not a free country.

Yet nobody questions it.

Listen to a Fed press conference and all you’ll hear is how many times will you hike rates?  Do you support 25 or 50 basis points?  Is the Fed too late in the curve?  Will higher rates choke off growth?  Will higher rates bring inflation to heel?

In my entire adult life, not one economist at a Fed presser has asked a good question.  

So here’s one.  Why set rates so low in the first place that they discourage savings and promote borrowing and spending? Isn’t that the opposite of sound financial strategy?

Or how about this?  The US Constitution directs Congress to fix exchange rates for our currency and to back it with just weights and measures, which means with gold and silver. Why does the Fed defy the Constitution?

Because, Tim, gold and silver are stupid antiquated notions about money.

Well, it’s the law in black and white, hasn’t been changed. But government has decided its opinions are superior to the law. In many instances. But I digress.

John Maynard Keynes, the father of deficit spending, said, “The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

You can’t suck all the value out of money backed by metal.

How does inflation debauch capitalism? Businesses struggle to deploy labor and capital to produce goods and services at predictable returns. Consumers who trade time for money can’t make ends meet and become state dependents.

Yes, hourly workers are hurt most. Then the government has the audacity to blame capitalism for the growing wealth gap. No, the Fed does it. Rich people can surf the inflation wave. Poor people can’t.

The problem isn’t higher rates. It’s LOW RATES to begin.

Low rates increase the supply of currency faster than output, which means everybody’s money buys less. The money supply the last two years rose from $16-$22 trillion.

The definition of inflation should be “low interest rates,” because the inevitable consequence is more money chasing the same goods instead of getting saved, invested.

If we wanted people to save, we’d reward them for it. Why don’t we? Because the Fed exists – no matter its pronouncements of independence – to keep the federal government and its policies afloat. Which requires CONSUMPTION. Not saving.

Even if it’s contrary to the interests of the citizenry.

What if we lifted rates to 10% and left them there?  A bunch of stuff would go broke.  Probably our government.

Too high a price? If we want money that buys more over time rather than less, that generates a return when you save it so we become less indebted, less dependent, we have to either bankrupt the government or take away its printing press.

Maybe both.

We will never be financially responsible as a society so long as the Federal Reserve uses interest rates to allocate labor and capital, and the government is printing money.

That is the problem to solve. Everything else is a failure to address the problem.

So, will we?  I’d wager all that Fed paper blighting the fruited plain that it’ll continue until nobody wants dollars (we’re helping Russia, in fact).

Or we could instead fix it.  Anyone?

Weird

This is weird. 

I’m traveling to an actual business meeting, by aircraft, and I intend to wear a suit.

Illustration 155967106 / Dune © Rolffimages | Dreamstime.com

There are many things in our society that I had considered weird but these two were not among them.  It’s pretty weird seeing Will Smith slap Chris Rock, who took it with aplomb while the Hollywood audience weirdly applauded.

But that’s not what I was thinking about.

Currently among the weirdest – by no means alone – is the divide between what people think is true about the stock market and what actually is. 

Which I suppose makes it somewhat less weird that my suit-wearing face-to-face is with American manufacturing firms in Atlanta at the MAPI conference. That’s the Manufacturers Alliance for Productivity and Innovation.

I’ve been invited to talk about how Passive Investment profoundly shifts the center of gravity for the investor-relations profession, liaison to Wall Street.

Glad to see these companies caring about their stock market.

And it’s not ESG causing the big shift.  Without offense to those advocating the hot ESG zeitgeist gusting globally, it’s yet another way for public companies to do qualitative work turning them into quantitative trading products.

You may not like that characterization. Well, scores are quantitative measures. Score something, and somebody will trade that score against another – exactly the way sports athletes are, or wine-rankings are, or restaurants on Open Table are.

Long-only investment is qualitative, like writing an essay.

Well, get this.  Active Investment is almost 50% higher in SPY, the S&P 500 ETF, than it is on average in stocks actually comprising the S&P 500.

Public companies, it means stock-pickers invest more in SPY than in the fundamentals of individual stocks. That is a statistical and irrefutable fact.

The problem isn’t you. The problem is the market. 

SPY has a 50-day average of 1.2 million trades per day, and over $53 billion of daily dollar flow. TSLA alone comes remotely in range at $25 billion, half SPY’s colossus. AAPL is a distant third at $15 billion.

Public companies continue to do ever more to ostensibly satisfy what investors want.  And they’re buying SPY.

If the SEC persists in implementing regulations with no precedent legislation – which will mark a first in American history – soon you’ll face mandatory climate disclosures.

So, from the Securities Act of 1933 implementing reporting rules for public companies, through 2022, the amount of information issuers are required to disgorge has become a sandstorm right out of the movie Dune. 

And investors are just buying SPY.

That should exercise you, public companies.  You bust your behinds delivering financial results, blowing sums of Congressional proportion populating the fruited plain with data.

And investors just buy a derivative, an ETF with no intrinsic value or story or results.

Years ago we studied the SPY data, measuring creations and redemptions and trading volume in the world’s largest ETF. We found that 96% of it was arbitrage – aligning SPY with the basket of 500 stocks it tracks.

But because the amount of Active Investment is significantly greater in SPY than the average one of those 500 stocks, we know stock-pickers well outside the S&P 500 are simply using it as a proxy for bottom-up investing too.

So, what should we do as a capital-markets constituency? 

The first rule of holes is when you’re in one, stop digging.  If we want to dig something in, how about our heels?  The entire contingent of public companies should rise up and tell regulators to pound sand.

That you will no longer comply with any further disclosures until the SEC makes markets more hospitable to the investors we work our fingers to the bone to court.

Because it’s not working. 

Why?

The SEC has overridden the stated purpose of the law that created it – notwithstanding that Congress had no Constitutional authority to regulate financial markets in the first place because the states never delegated it by amendment to federal government – which is to foster free, fair and unimpeded capital markets.

Instead the SEC decreed that the purpose of the market would be a continuous auction. Creating prices. And so investors are forced to own things with enough prices to permit them to get in and out.

For stupidity, it’s right up there with Will Smith slapping Chris Rock.

But we’ve got ourselves to blame. Public companies have not cared enough about the market to even pay attention to how it works. So we have a market that sets vast numbers of prices but impairs investment.

If you want to know how the stock market works, use our Market Structure Analytics for a year.  See what really happens. Then you can fight back. Maybe you’ll be moved to storm the regulatory Bastille and bring an end to this aristocratic crap.

That would be weirdly and wildly and wonderfully beautiful.

Caveat Short Emptor

What’s 218 pages and heavily footnoted? 

No, not an Act of Congress. Federal laws are ten times longer or treated as unserious.

It’s the new SEC proposed short-sale rule.

Illustration 129811007 © | Dreamstime.com

I admit, I was excited. As the sort who read Tolstoy’s War and Peace in high school and in college relished French symbolism and theological exegesis – finding meaning in dense and inscrutable texts – what could be more compelling than an SEC rule proposal?

Well. Hm.

Under the Gensler regime, the SEC has engaged in hyperventilating levels of rulemaking while suppressing discourse. Between Feb 9-Mar 21, 2022, the SEC issued six MAJOR rule proposals.

How the hell can we read them – even me – let alone respond substantively?

Politburos do that.

We want fair markets. I support short-sale disclosure. 

But not at the expense of discussion or at the cost of permitting the SEC to regulate matters over which it has no authority.

Contrary to popular belief at the SEC, it’s not omniscient in our financial pursuits. It exists to reduce the risk of fraud in public equity and fixed-income markets.

It could be argued the Constitution enumerates no such federal authority at all. Whatever the case, if a power enlarges like a prostate, it’s probably cancerous.

Cough, cough.

Back to the short-sale rule. Dodd-Frank legislation after the Financial Crisis – crises always diminish liberty (and seem to thus compound) – directed the SEC to implement short-sale reporting, so investors and public companies would know who’s doing it.

The Fact Sheet for Rule 13f(2), as it’s called, says the principal purpose is to “aid the Commission in reconstructing significant market events and identifying potentially abusive trading practices, including short squeezes.”

Are short squeezes abusive?  I thought the purpose of the Exchange Act that created the SEC was to promote transparent and equitable markets.  Did you know that the compulsory disclosures public companies are making today under forms 10Q and 10K date to 1933 and 1934? You think the market functions anything like it did then?

If you do, you haven’t read Regulation National Market System. I have. I read the Federalist Papers for fun, to hear the mellifluous wonder of the English language.

For those struggling with math, it was 88 years ago. Not the Federalist Papers, the Exchange Act of 1934. Automobiles and electricity weren’t ubiquitous on the fruited plain yet then, let alone cell phones, algorithms, and electronic markets.

Now the SEC is regulating to give itself information, not to give the public information.

Again, I’m for transparency. The proposal says: 

Form SHO would require that institutional money managers file on the Commission’s EDGAR system, on a monthly basis, certain short sale related data, some of which would be aggregated and made public. Certain data, including the identities of such managers and individual short positions, would remain confidential.

Wait, what?

The SEC would get a bunch of data, and the rest of us would see anonymous aggregated meaningless stuff. 

Got that?

Yes, the rule proposes that investment managers report short positions greater than $10 million, or average shorting of 2.5% of outstanding shares monthly.  BUT, not by fund.

It’s anonymous data.

So really, PUBLIC COMPANIES get penalized. Everybody would know which stocks are getting the hell pummeled out of them – but not by who.

What does that promote? Mob behavior.

You have to read what the SEC says. For that matter, you should read what the exchanges say when they file to implement regulations.  It may not be what you think.

And while the SEC will collect more data, the biggest source of shorting in the stock market, the market-making exemption from Reg SHO Rule 203(b)(2), is undaunted.

Yes, brokers will have to report “buy to cover” orders or class them as exempt under the provision above.  What would you do as a broker? Report them or class them exempt?

Let me explain. Brokers will continue to be permitted to short stock without locating it, because the SEC thinks the principal purpose of the stock market is to form PRICES, not CAPITAL.

But they will promote an artifice called “short-sale reporting.”

I’m offended by that. The SEC should be mandating 13F reporting monthly for long and short positions. That the Commission instead wants short positions without names each month and long positions by name 45 days after the end of the quarter is sententious.

Quast, what does that mean? Pompous moralizing.

We don’t have legislative authority to mandate monthly long-reporting, the SEC will say. Hypocrites. The SEC just issued climate-disclosure rules with no legislative authority.

The SEC has forgotten its purpose: Free, fair and transparent markets.

Instead, it’s after power, political agendas. Not truth. By the way, see comments here (and I LOVE Patrick Hammond’s). Let’s add to them.

We should reject that impulse, even if it means waiting longer for a rethinking of 88-year-old disclosure standards.

Suspended

Shocking.

No other word for it.

Yesterday as VIX volatility futures settled on an odd Tuesday, Barclays suspended two of the market’s biggest Exchange Traded Notes (ETNs), VXX and OIL.

Let me explain what it means and why it’s a colossal market-structure deal.

VXX is the iPath Series B S&P 500 VIX Short-Term Futures ETN. OIL is the iPath Pure Beta Crude Oil ETN (OIL). iPath is a prominent Barclays brand. Barclays created the iShares line that Blackrock bought.  It’s an industry pioneer.

Illustration 76839447 © Ekaterina Muzyka | Dreamstime.com

These are marketplace standards, like LIBOR used to be.  This isn’t some back-alley structured product pitched from a boiler room in Bulgaria (no offense to the Bulgarians).

Let’s understand how they work. ETNs are similar to Exchange Traded Funds (ETFs) in that both trade like stocks.  But ETNs are unsecured, structured debt.

The aim of these particular notes is to pay the return via trading reflected in crude oil, and volatility in the S&P 500 stock index. 

OIL uses quantitative data to select baskets of West Texas Intermediate oil futures that the model projects will best reflect the “spot” market for oil – its immediate price.  But nobody owning OIL owns anything. The ETN is just a proxy, a derivative.

VXX is the standard-bearer for trading short-term stock-volatility. It’s not an investment vehicle per se but a way to profit from or guard against the instability of stock-prices.  It’s recalibrated daily to reflect the CBOE Volatility Index, the VIX.

In a nutshell, a security intended to give exposure to volatility was undone by volatility.

I loved this phrase about it from ETF.com: “Volatility ETPs have a history of erasing vast sums of investor capital over holdings periods as short as a few days.”

ETP is an acronym encompassing both ETFs and ETNs as Exchange Traded Products.

It’s not that Barclays shut them down. They continue trading for now. The bank said in a statement that it “does not currently have sufficient issuance capacity to support further sales from inventory and any further issuances of the ETNs.”

ETF industry icon Dave Nadig said, “The ‘Issuance Capacity’ thing is a bit of a get out of jail free card, so we can interpret that as ‘we no longer feel comfortable managing the implied risk of this product.’”

Barclays said it intends to resume supporting the funds at some future point. But we’ll see.  Credit Suisse ETNs that failed in Mar 2020 amid Pandemic volatility were stopped temporarily too but suspensions became permanent.

The lesson is clear. The market is too unpredictable to support single-day bets, which these instruments are principally designed for. 

I’ve long written about the risks in ETPs. They’re all derivatives and all subject to suddenly becoming worthless, though the risk is relatively small.

And it’s incorrect to suppose it can happen only to ETNs. All tracking instruments are at risk of failure if the underlying measure, whatever it is, moves too unpredictably.

You might say, “This is why we focus on the long-term.  You can’t predict the short-term.”

Bosh. Any market incapable of delivering reliable prices is a dysfunctional one.  It’s like saying, “I don’t know what to bid on that Childe Hassam painting but I’m sure over the long-term it’ll become clear.”

Bluntly, that’s asinine. Price is determined by buyers and sellers meeting at the nexus of supply and demand.  If you can’t sort out what any of that is, your market is a mess.

It remains bewildering to me why this is acceptable to investors and public companies. 

It’s how I feel about empty store shelves in the USA. No excuses. It reflects disastrous decisions by leaders owing a civic duty to make ones that are in our best interests.

Same principle applies. We have a market that’s supposed to be overseen in a way that best serves investors and public companies. Instead it’s cacophony, confusion, bellicosity, mayhem.

At least we at ModernIR can see it, measure it, explain it, know it.  We’ve been telling clients that it’s bizarre beyond the pale for S&P 500 stocks to have more than 3% intraday volatility for 50 straight days. Never happened before.

Well, now we know the cost.

Oh, and the clincher? VIX options expired yesterday. Save for four times since 2008, they always expire on WEDNESDAY. Did one day undo Barclays?  Yes.

That’s why market structure matters. Your board and c-suite better know something about it.